Friday, 3 July 2009

A Rolling Stone gathers no moss...

A few stories have caught the eye in the last week that potentially tell us a little about where derivatives / financial markets are going.

Firstly this week saw the launch of Indices for sovereign CDS. The Alphaville Blog post and comments really summarize this, in particular the first comment which begins, “This is a pointless punting instrument”.
- What exactly could you hedge with this?
- Who would you buy the hedge from?
- Which currency would you denominate it in?
In short this is a very awkward hedging tool and a very useful trading / speculating tool.

If that is the private side response to the current situation the public one is not too dissimilar. The US and others are still calling for more standardized derivatives as a key part of the regulatory overhaul. Indeed we have seen standard CDS coupons put in place in the US and in Europe.
- Does standardisation bring derivatives closer to production, giving capitalists a risk management tool to help them manage their specific business risks? NO.
- Does standardization help those that want to trade vast volumes of derivatives? YES
- Does standardization and large volume trading help speculators? YES
- Does anyone still think that the problem with CDS pre-crisis was not enough volume? That price efficiency will follow if we can just make the market ‘purer’? SURELY NOT!?

Finally, in the same vein of financial instruments divorcing further from production and becoming simply investment vehicles Bloomberg noted that correlation between asset classes is at all time highs. “The Standard & Poor’s 500 Index … is rallying in tandem with benchmark measures for raw materials, developing- country equities and hedge funds.”

The fact of ever increasing numbers of asset prices moving in lockstep would be consistent with the rise of anything and everything as an investment vehicle. Now the forces of supply and demand for the investment outstrip the forces of demand and supply from production. Herd mentality, risk aversion and so on rule the roost (incidentally, fear is often said to manifest itself in the VIX another abstractr index; Macro Man notes “for the first time in quite a while, the ambient temperature in SE England is higher, in degrees Celsius, than the VIX.” – a vital technical???)

Why does this matter? Well first of all the alleged benefits of derivatives and financial markets are risk sharing, hedging and so on. Surely these are best served if derivatives move towards and not away from production, become more hedger friendly not less. Secondly the further from production the more fictitious financial prices become and the more open to herd behavior, bubbles and outright manipulation. This leaves financial capitalists in the position we find them now of trading the hell out of the markets as they rise and resisting the fall by either getting out at the top or using their political clout to avoid the consequences.

Which leads finally to a piece in Rolling Stone magazine highlighting the activities of those Masters of the Universe, Goldman Sachs. It shows in irreverent language but damning detail how bankers inflated and rode the dot com, the housing and the oil bubbles, have come out of the crisis bailout as shiny as ever and how they are now looking at global warming, carbon markets and the rest as the new “asset class”.

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